How to Earn Profit From Stock Buybacks or Share Repurchases?

Stock buybacks or share repurchases are a popular method by which cash-rich companies return capital to their shareholders. With markets becoming increasingly profitable, understanding the concept of share repurchases can offer retail and institutional investors a unique opportunity to maximise their returns. 

Through this blog, we will understand how stock buybacks work, their impact on stock prices, and how investors can benefit from them.

What are Stock Buybacks?

A stock buyback occurs when a company buys back its own shares directly from shareholders, reducing the total number of outstanding shares. Stock buybacks often increase the stock price.

Companies engage in stock buybacks for several reasons:

• Boosting Share Value: The reduction in the number of shares increases the earnings per share (EPS), making the stocks more attractive.
• Raising Undervalued Stock Price: When companies believe their stock is undervalued, they resort to stock buyback policies.
• Tax Efficiency: Stock buybacks investing is often more profitable than dividends as they may offer tax advantages.
• Confidence Building: The management often initiates buybacks to signal confidence amongst the shareholders in the company’s future growth.
• Prevent Hostile Takeover: The companies choose to buyback shares, which results in a decrease in the number of shares available to be bought by companies interested in acquiring them. Share repurchase, in this case, acts as a defence mechanism to thwart hostile takeovers. 

Regulatory Framework in India

To ensure transparency, share buybacks are governed by the Companies Act, 2013 and the SEBI Regulations for Buy-Back of Securities. These regulations specify the maximum limit for buybacks, the method of repurchase (tender offer or open market), and the cooling-off period before a company can initiate another buyback. Also, companies must ensure they are using free reserves or surplus cash for the buyback and meet solvency criteria after the process. To protect the shareholders’ interest, the corporate finance impact of the buyback must be disclosed. 

Methods of Share Buyback

Companies can conduct buybacks through various methods, such as

• Tender Offers: Shares are bought at a fixed price from existing shareholders.
• Open Market Purchases: In this method, companies purchase shares from the secondary market over time.
• Book Building Process: In this method, the shareholders bid for the shares in the buyback process.

Stock Price Impact of Buybacks

The fundamental principle of supply and demand applies to the concept of stock buyback. When a company repurchases its shares, the stock price impact is reflected in the:

• EPS Increases: The company’s stock becomes more attractive as fewer shares in circulation lead to a rise in earnings per share.
• Stock Price Appreciation: Sometimes, news of a buyback is enough to improve the market perception, increasing the company’s stock price.
• Reduced Volatility: Buybacks can help stabilise stock price movements, thereby reducing sharp fluctuations during market instability.
• Enhanced Metrics: Fewer outstanding shares lead to improved return on equity (ROE) and return on assets (ROA), making the company look more profitable. 

How Investors Can Profit From Stock Buybacks?

The following strategies can be implemented to effectively leverage stock buyback investing:

• Identifying Companies with Profitable Buyback Plans

Company announcements, regulatory filings, and news about planned share repurchases can be found in BSE and NSE as mandated by SEBI. Monitor these websites for relevant information.

• Analysing the Motivation Behind Buybacks

Investors should evaluate the following reasons why buybacks might be profitable:

1. Company Fundamentals: Ensure the company has a strong corporate finance base and earnings growth.
2. Debt Levels: The company funding the buyback must have a minimal debt level.
3. Past Performance: Buybacks from companies with a good historical performance in the market are preferable.

• Timing the Market

Stock buyback investing is an excellent entry point for investors as they usually signal undervaluation. However, investors should remember to:

1. Avoid buying immediately after a buyback announcement due to a temporary hike in stock price.
2. Track the stock’s performance over a few weeks before purchasing.

• Sectoral Buyback Trends

Investors should check historical buyback patterns in certain sectors, such as IT, banking, FMCG, etc., which regularly announce buybacks due to excess cash surplus.

• Comparing Buybacks vs. Dividends

While dividends provide immediate income, buybacks are for long-term capital gains. Buybacks are more favourable for investors with a long-term horizon.

Advantages of Share Buybacks

Some of the benefits of repurchasing or buying back shares include the following:

• Share repurchase reflects the management’s positive prospects.
• Buybacks are also used as a preventative measure against the reissuing of shares. This is to balance the business’s capital structure.
• Share buybacks enable companies to raise their stake and control over the businesses, preventing hostile takeovers.
• It helps monitor businesses with low liquidity as Section 77B of the Companies Act 1956 prohibits such companies from share buybacks.
• Fresh issues dilute equity but stock buybacks investing consolidate holdings of investors by increasing relative share, without any additional investment.
• Stock buybacks investing also offer a profitable exit option as the buyback price is normally set at a smart premium to market price. 

Limitations of Share Buybacks

While stock buybacks are rewarding opportunities, they may also carry risks.

• It might indicate fake stock inflation. Stock prices may be inflated to an unsustainable level if buybacks are not backed by real earnings.
• Funds used for buybacks can impair other businesses, leading to missed investment opportunities.
• It is considered an unethical way of increasing promoters’ ownership stake.
• Buybacks might indicate the company does not have too many profitable investment opportunities and hence it is sharing and distributing surplus cash in the form of share buybacks. 

Conclusion

Stock buybacks play an important part for Indian investors looking to capitalise on corporate finance decisions. Buybacks from companies with strong fundamentals can enhance portfolio returns. On the other hand, buybacks motivated by short-term stock price manipulation can be disastrous to an investor’s portfolio. Hence it is important to have the right approach to reap the benefits of share buyback policies. 

Maximise your returns with expert share buyback strategies—Start with Torus Digital today!”